Stepping Away from the Active vs. Passive Debate

February 4, 2014 - 0 comments

In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management. The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market. Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time. It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.

At PWL we are happy to disagree with the idea of active management, but we don’t consider our style of investing to be passive either. Market-based investing is the idea of harnessing what the market has to offer, while tilting portfolios towards specific parts of the market that have been shown by years of data to produce higher expected returns; the tilts are toward small stocks, and value stocks. There is minimal research and trading required to maintain these portfolios, so costs are low. Of the many markets around the world, Canada only represents about 4% of the total capitalization, the US represents about 46%. If we tried to determine which markets would be the best to invest in at any given time, we would be betraying our scientific approach in favor of using our intuition. Our solution is to build globally diversified portfolios in order to capture returns of markets around the world while reducing the impact of any single market.

So we have these globally diversified portfolios tilted towards specific asset classes, but how do we react if a geography or asset class is performing poorly? We buy more. Conversely, if a piece of the portfolio surges we will sell as soon as the predetermined allocations are out of balance. By systematically rebalancing our portfolios we are able to reduce overall volatility while increasing expected returns. Using this rules-based system ensures that emotions and predictions are removed from investment decisions, and it sets PWL apart from the active vs. passive debate.